All the problems in using unadjusted operating income described in Chapter 4 continue to apply. If the current return on capital for a firm is significantly higher than the industry average, the forecasted return on capital should be set lower than the current return to reflect the erosion that is likely to occur as competition responds.
Finally, any firm that earns a return on capital greater than its cost of capital is earning an excess return. High excess returns locked in for very long periods imply that this firm has a permanent competitive advantage.
The reinvestment rate for a firm can be negative if its depreciation exceeds its capital expenditures or if the working capital declines substantially during the course of the year. For most firms, this negative reinvestment rate will be a temporary phenomenon reflecting lumpy capital expenditures or volatile working capital. This is what we did for Embraer in the Illustration above. For some firms, though, the negative reinvestment rate may be a reflection of the policies of the firms and how we deal with it will depend upon why the firm is embarking on this path:.
If this is the case, we should not use the negative reinvestment rate in forecasts and estimate growth based upon improvements in return on capital. Once the firm has reached the point where it is efficiently using its resources, though, we should change the reinvestment rate to reflect industry averages. In this case, the expected growth should be estimated using the negative reinvestment rate.
Not surprisingly, this will lead to a negative expected growth rate and declining earnings over time. The analysis in the previous section is based upon the assumption that the return on capital remains stable over time. If the return on capital changes over time, the expected growth rate for the firm will have a second component, which will increase the growth rate if the return on capital increases and decrease the growth rate if the return on capital decreases.
So far, you have looked at the return on capital as the measure that determines return. In reality, however, there are two measures of returns on capital. One is the return earned by firm collectively on all of its investments, which you define as the average return on capital.
The other is the return earned by a firm on just the new investments it makes in a year, which is the marginal return on capital. Changes in the marginal return on capital do not create a second-order effect and the value of the firm is a product of the marginal return on capital and the reinvestment rate. Changes in the average return on capital, however, will result in the additional impact on growth chronicled above.
What types of firms are likely to see their return on capital change over time? One category would include firms with poor returns on capital that improve their operating efficiency and margins, and consequently their return on capital. In these firms, the expected growth rate will be much higher than the product of the reinvestment rate and the return on capital.
In fact, since the return on capital on these firms is usually low before the turn-around, small changes in the return on capital translate into big changes in the growth rate. The other category would include firms that have very high returns on capital on their existing investments but are likely to see these returns slip as competition enters the business, not only on new investments but also on existing investments. The third and most difficult scenario for estimating growth is when a firm is losing money and has a negative return on capital.
Since the firm is losing money, the reinvestment rate is also likely to be negative. To estimate growth in these firms, you have to move up the income statement and first project growth in revenues. If the expected margin in future years is positive, the expected operating income will also turn positive, allowing us to apply traditional valuation approaches in valuing these firms.
You also estimate how much the firm has to reinvest to generate revenue growth, by linking revenues to the capital invested in the firm. Many high growth firms, while reporting losses, also show large increases in revenues from period to period. The first step in forecasting cash flows is forecasting revenues in future years, usually by forecasting a growth rate in revenues each period.
In making these estimates, there are five points to keep in mind. Firms can post higher growth rates in revenues by adopting more aggressive pricing strategies but the higher revenue growth will then be accompanied by lower margins.
Before considering how best to estimate the operating margins, let us begin with an assessment of where many high growth firms, early in the life cycle, stand when the valuation begins. They usually have low revenues and negative operating margins. If revenue growth translates low revenues into high revenues and operating margins stay negative, these firms will not only be worth nothing but are unlikely to survive.
For firms to be valuable, the higher revenues eventually have to deliver positive earnings. In a valuation model, this translates into positive operating margins in the future. A key input in valuing a high growth firm then is the operating margin you would expect it to have as it matures.
In estimating this margin, you should begin by looking at the business that the firm is in. While many new firms claim to be pioneers in their businesses and some believe that they have no competitors, it is more likely that they are the first to find a new way of delivering a product or service that was delivered through other channels before. Thus, Amazon might have been one of the first firms to sell books online, but Barnes and Noble and Borders preceded them as book retailers.
In fact, one can consider online retailers as logical successors to catalog retailers such as L. Bean or Lillian Vernon. Similarly, Yahoo! Using the average operating margin of competitors in the business may strike some as conservative. After all, they would point out, Amazon can hold less inventory than Borders and does not have the burden of carrying the operating leases that Barnes and Noble does on its stores and should, therefore, be more efficient about generating its revenues and subsequently earnings.
This may be true but it is unlikely that the operating margins for internet retailers can be persistently higher than their brick-and-mortar counterparts. If they were, you would expect to see a migration of traditional retailers to online retailing and increased competition among online retailers on price and products driving the margin down.
While the margin for the business in which a firm operates provides a target value, there are still two other estimation issues that you need to confront. Given that the operating margins in the early stages of the life cycle are negative, you first have to consider how the margin will improve from current levels to the target values.
Generally, the improvements in margins will be greatest in the earlier years at least in percentage terms and then taper off as the firm approaches maturity. The second issue is one that arises when talking about revenue growth. Firms may be able to post higher revenue growth with lower margins but the trade off has to be considered.
While firms generally want both higher revenue growth and higher margin, the margin and revenue growth assumptions have to be consistent. The Fundamental Determinants of Growth With both historical and analyst estimates, growth is an exogenous variable that affects value but is divorced from the operating details of the firm.
Growth in Operating Income Just as equity income growth is determined by the equity reinvested back into the business and the return made on that equity investment, you can relate growth in operating income to total reinvestment made into the firm and the return earned on capital invested.
Stable Return on Capital Scenario When a firm has a stable return on capital, its expected growth in operating income is a product of the reinvestment rate, i. Reinvestment Rate The reinvestment rate measures how much a firm is plowing back to generate future growth. Return on Capital The return on capital is often based upon the firm's return on existing investments, where the book value of capital is assumed to measure the capital invested in these investments.
Negative Reinvestment Rates: Causes and Consequences The reinvestment rate for a firm can be negative if its depreciation exceeds its capital expenditures or if the working capital declines substantially during the course of the year. If they choose to reinvest in a bond offering a 3. An investor who expects interest rates to rise might select a shorter-term investment under the assumption the reinvestment rate when the bond or CD matures will be higher than the interest rates that can be locked for longer-maturity investments.
When a bond is issued, and interest rates increase, an investor faces interest rate risk. Since bond prices fall when interest rates rise, an investor holding a fixed-rate bond may experience a capital loss if the bond is sold before its maturity date. The longer the time period until maturity, the greater the bond is subject to interest rate risk. Because a bondholder is given the face amount at maturity, bonds nearing the maturity date have little interest rate risk.
Investors can reduce interest rate risk by holding bonds of different durations and by hedging their investments with interest rate derivatives. When interest rates decrease, the price of a fixed-rate bond increases. An investor may decide to sell a bond for a profit. Holding onto the bond may result in not earning as much interest income from reinvesting the periodic coupon payments.
This is called reinvestment risk. When interest rates decline, interest payments on bonds also decrease. Instead of making coupon payments to the investor, some bonds reinvest the coupon into the bond, so it grows at a stated compound interest rate.
When a bond has a longer maturity period, the interest on interest significantly increases the total return and might be the only method of realizing an annualized holding period return equal to the coupon rate. Calculating reinvested interest depends on the reinvested interest rate.
Portfolio Management. Fixed Income Essentials. Interest Rates. Certificate of Deposits CDs. Your Money. Personal Finance. Your Practice. Popular Courses. What Is a Reinvestment Rate?
The term total reinvestment rate refers to a metric that allows the investor-analyst to understand how much money a company is reinvesting in itself. The calculated rate uses EBITDA in the denominator, which eliminates the effects of both financing decisions as well as accounting practices. Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term.
One of the ways to understand managements' dedication to the business is by determining the company's total reinvestment rate. By calculating a company's total reinvestment rate, the investor-analyst can understand if the company's management team is determined to grow the business both organically as well as through acquisitions. While the rate will allow the investor-analyst to understand how much money the company is plowing back into its business, it does not provide an indication of the return on that investment.
In theory, shareholders should demand the company pay dividends when the returns on internal investments are inadequate. In the world of finance, the time value of money concept helps define and compare the value of current and future cash flows. When financial analysts calculate the widely used internal rate of return metric, called IRR, the calculation is based on a selected reinvestment rate assumption.
The reinvestment rate assumption definition is derived from this process. This means that in the calculation, any cash flow — such as earnings, interest, rents or dividends — are reinvested at the assumed rate. The rate assumption for reinvestment can have a significant effect on the projected results for an investment or project.
When you look at your projected investment returns, a major consideration is what happens to earnings such as dividends and interest payments. With a mutual fund, you can have dividends automatically reinvested into more shares, compounding the rate paid by the fund.
With stock dividends or bond interest, if those cash payments just build up in your brokerage account, you do not have much in the way of a reinvestment rate. If you do not reinvest your earnings at a rate similar to your growth assumptions, the result is a lower probability of meeting your investment growth goals. With bond investments, reinvestment rate assumption is cooked into the rates quoted by your broker. The yield-to-maturity rate for a bond assumes that the interest coupon payments will be reinvested at the same rate as the calculated yield-to-maturity quoted for the bond.
If the interest payments are not reinvested or get invested at a lower rate, the total return from the bond will be slightly less than the quoted yield-to-maturity rate if the bond is held until it matures and the principal pays off. If your investment goals include the long-term growth of your portfolio value, develop a plan concerning earned dividends and interest.
Put together your own reinvestment rate by using the portfolio earnings to buy more investments that will pay additional income. Earned cash can also be used to implement an asset allocation strategy, investing the money when you rebalance your portfolio assets, avoiding some of the selling that would be necessary if you did not have the earned and accumulated cash to invest.
Tim Plaehn has been writing financial, investment and trading articles and blogs since
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